In Discussion paper No 1308, Research Fellows Richard E Baldwin and Jan Haaland and Rikard Forslid study the investment creation and investment diversion effects of the EU's Single Market programme (EU92). The paper first discusses suggestive empirical evidence, then it presents an illustrative theoretical model, and finally it goes over a set of simulations from a general equilibrium model with endogenous capital stocks. Empirical evidence indicates that EU92 probably led to investment diversion in the economies of the European Free Trade Association (EFTA) and investment creation in the EU economies. This is quite clear when it comes to net foreign direct investment flows. It is less clear that macroeconomic investment-to-GDP ratios were subject to creation or diversion effects.

In their theoretical model the authors illustrate the main channel through which discriminatory integration leads to investment creation and diversion. The core mechanism focuses on the derived demand for capital. Discriminatory liberalization shifts production from excluded countries to the integrating region. Since EU92 focused on tradable sectors and these are capital intensive, the production shifting raises the rental rate in the integrating regions, lowering it elsewhere. The simulations confirm the possibilities of investment diversion. The results are quite sensitive to the structure of the model, however, and to the structural changes that take place in the economies. Simulation results show that investment diversion does occur for the EFTA6 when EU92 involves market integration in addition to real trade cost reduction. When EU92 is extended to include the EFTA6, EFTA6 capital stocks rise by almost 5%. In terms of real income, the difference between the EFTA6-included and EFTA6-excluded cases is quite large for the EFTAns amounting to 5.5% of GDP. In all cases, the EU countries experience investment creation and real income gains. The effects on the United States and Japan are trivially small, but mostly negative in terms of capital stocks and real income.